Thursday, July 03, 2014

The financial instability argument for raising rates: ... Let’s call the proposition that we should raise rates now to avoid financial instability the BIS case, after the Bank of International Settlements who have been making this argument ever since the recession began. ...

I want to begin by conceding a point. Suppose, as a monetary policymaker, you believe a financial crisis is possible, and that by raising rates you may be able to prevent it. Assume, crucially, that there is nothing else you can do to help prevent the financial crisis. In that case, you will consider raising rates, even if inflation is below target. ...

However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused. ... So by raising rates by a modest amount today we might prevent financial instability, but at the cost of delaying the recovery. ...

As Ryan Avent says, we can avoid all these difficulties by adding an extra instrument, which is macroprudential regulation. ... Now, as R.A. notes, those taking the BIS position counter that such measures are untested and may not be effective. Here is a typical example in the FT, where it is stated that “macroprudential policies will fail to stop investors taking irrational risks”.

So we must raise interest rates, and delay the recovery, because nothing else can stop some in the financial system taking excessive risks. To which I can only say, summoning all my academic gravitas, what audacity, what impudence! Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again. I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.

... Well, I think my main theme here today is that macroprudential policies should be the main line of defense, and I think the efforts that we’re engaged in in the United States but all countries coordinating through the — through Basel, through the Financial Stability Boards — the efforts that we are taking to globally strengthen the resilience of the financial system: more capital, higher quality capital, higher liquidity buffers, stronger and — arrangements for central clearing of derivatives that reduce interconnectedness among systemically important financial institutions, strengthening of the architecture of payments and clearing system dealing with risks we see in areas like tri-party repo. ...

I would also put resolution planning which we’re engaging in actively as among those measures. And, you know, as I mentioned, I think cyclical policies and sector-specific policies that we’re seeing many emerging markets take steps that can be used, particularly when we see problems developing in housing or a particular sector. These are really promising.

I don’t think we yet understand how they work. When they can be effective, how we should use them. I hope this will be an area for the IMF and for us of active research so we can better deploy those tools, capital — countercyclical capital charges.

But I think importantly, I’ve not taken monetary policy totally off the table as a measure to be used when financial excesses are developing because I think we have to recognize that macroprudential tools have their limitations. ... So to me, it’s not a first line of defense, but it is something that has to be actively in the mix. ...

I think the macroprudential approach is correct. Using interest rates to deal with pockets of financial instability is too blunt of an instrument, e.g. it hits all industries, not just the ones where the instability is suspected and it may not directly address the particular problem generating the instability. It's much better to target the sectors where the problems exist, and to shape the policies to directly address the underlying problem(s).

The financial instability argument for raising rates: ... Let’s call the proposition that we should raise rates now to avoid financial instability the BIS case, after the Bank of International Settlements who have been making this argument ever since the recession began. ...

I want to begin by conceding a point. Suppose, as a monetary policymaker, you believe a financial crisis is possible, and that by raising rates you may be able to prevent it. Assume, crucially, that there is nothing else you can do to help prevent the financial crisis. In that case, you will consider raising rates, even if inflation is below target. ...

However that is not the end of the story. If you raise rates to prevent financial instability when inflation is below target, inflation will remain below target or may fall even further. You cannot ignore that. So if interest rates are raised today to head off a financial crisis, they will have to be lower in the future to deal with the lower inflation or even deflation you have caused. ... So by raising rates by a modest amount today we might prevent financial instability, but at the cost of delaying the recovery. ...

As Ryan Avent says, we can avoid all these difficulties by adding an extra instrument, which is macroprudential regulation. ... Now, as R.A. notes, those taking the BIS position counter that such measures are untested and may not be effective. Here is a typical example in the FT, where it is stated that “macroprudential policies will fail to stop investors taking irrational risks”.

So we must raise interest rates, and delay the recovery, because nothing else can stop some in the financial system taking excessive risks. To which I can only say, summoning all my academic gravitas, what audacity, what impudence! Not only have we had to suffer the consequences of the Great Recession because of excessive risk taking within a largely unregulated financial system, we now have to cut short our main means of getting out of that recession because they might do it again. I do not know what planet these people are on, but if its mine, can they please get off and play their games elsewhere.

... Well, I think my main theme here today is that macroprudential policies should be the main line of defense, and I think the efforts that we’re engaged in in the United States but all countries coordinating through the — through Basel, through the Financial Stability Boards — the efforts that we are taking to globally strengthen the resilience of the financial system: more capital, higher quality capital, higher liquidity buffers, stronger and — arrangements for central clearing of derivatives that reduce interconnectedness among systemically important financial institutions, strengthening of the architecture of payments and clearing system dealing with risks we see in areas like tri-party repo. ...

I would also put resolution planning which we’re engaging in actively as among those measures. And, you know, as I mentioned, I think cyclical policies and sector-specific policies that we’re seeing many emerging markets take steps that can be used, particularly when we see problems developing in housing or a particular sector. These are really promising.

I don’t think we yet understand how they work. When they can be effective, how we should use them. I hope this will be an area for the IMF and for us of active research so we can better deploy those tools, capital — countercyclical capital charges.

But I think importantly, I’ve not taken monetary policy totally off the table as a measure to be used when financial excesses are developing because I think we have to recognize that macroprudential tools have their limitations. ... So to me, it’s not a first line of defense, but it is something that has to be actively in the mix. ...

I think the macroprudential approach is correct. Using interest rates to deal with pockets of financial instability is too blunt of an instrument, e.g. it hits all industries, not just the ones where the instability is suspected and it may not directly address the particular problem generating the instability. It's much better to target the sectors where the problems exist, and to shape the policies to directly address the underlying problem(s).